Investing: Why the “Unicorn” Herd is About to Get Thinned

There’s a rule of thumb that three points make a trend. I realized this morning, as I was talking to a private equity investor, that I have seen three clear events that tell me that we close to a bubble bursting.

Obviously there has been plenty of chatter for a while about there being a bubble. And yet valuations and market caps have continued to rise. And the world may not end on Monday morning either. But I now think we’re getting close.

There are plenty of people who are better qualified to offer serious technical analysis of the end of the world. Please just accept this as gut feeling of one investor–albeit one who has seen this wild roller coaster ride before.

1. The lack of effective diligence on Theranos

Venture Funds are not typically investing their own money. They are “hired” by limited partners to invest on their behalf. One of the ways that they “earn” management fees is by conducting thorough diligence on the companies in which they invest. One would reasonably assume that the bigger the check, the deeper the diligence. In the case of Theranos though, the company has raised $400-$700 million at a $9 billion valuation without apparently delivering the product that it said it had. Obviously in some cases, it’s hard to figure out whether a product will work in the future, however in this case, there’s mounting evidence that investors didn’t do even the most basic diligence–walking into a Walgreens and asking for a test. Bill Maris of Google Ventures, says in this Business Insider article that they passed in 2013 because Google believed that the Theranos technology was flawed. Good for the GV team, bad for the folks that subsequently wrote big checks. Sloppy diligence is both a hallmark of a latter stage bubble and a contributor to its rapid deflation. Fortune Magazine contributed this excellent timeline of the Theranos events.

2. The serious fraud at Oak Investment Partners

As I get older, it’s harder to shock me. I have just seen too many things before. And yet, to use that lovely British expression, I was gobsmacked by the revelations of serious fraud at and against Oak Investment Partners. Oak is one of the oldest and most respect venture funds. As a group they are also good guys. So when the Wall Street Journal reported in this front page article that Iftikar Ahmed had defrauded the company of $65 million dollars and fled the country, it had me shaking my head. While it’s fine to say that there should be trust among partners, it’s an almost comical notion that one can steal millions by essentially using whiteout to alter contracts and financial statements. Give a company $2 million but tell your partners that it’s $20 million. Add a “1” to a financial statement and turn $2 million of revenue into $12 million. Perhaps it was a little more complicated than that, but not much.

Again, it’s a bright flashing yellow light when tens of millions of dollars are being invested with only a cursory hand wave in diligence. It’s not happening at every venture firm and most startups up still struggle to get funded. But….

3. The expanding disconnect between private and public market valuations.

Historically, venture-backed companies dreamed of going public as a path to liquidity for both the team and investors. In the process of filing for an IPO, two things happen: private company financials get cleaned up and brought up to public accounting standards; and the company’s valuation becomes rationalized versus other public companies. This is not to say that the price always gets knocked down, but over the course of time, the market figures out what growth, innovation and excitement are worth versus steady profits and predictable revenue. Even stocks that start out as high flyers tend to revert recognizable market norms over time.

As the current bubble has extended, private market valuations have gotten progressively more aggressive than public valuations. Ironically this is a complete reversal of the traditional notion that private companies trade at a discount to public companies because their stock is less liquid.

The chart at the top of this article is a worrisome example of this trend. When the phrase “unicorn” was first used several years ago, it was applied to a rare, almost mythical creature, a private company with a valuation greater than $1 billion. And many of the early “unicorns” proved to be worth at least $1 billion. But, without discussing the merits of the individual companies, the sheer volume of “unicorns” says that there’s something wrong with the system. Unicorns are not herd animals.

This valuation trend can extend for a while however ultimately investors want an exit. Typically an exit will either be an IPO or an acquisition by a public company. In either case, these companies will be hard-pressed to justify these valuations.

Is the world going to end? No. But I do expect a serious thinning of the unicorn herd over the next year. As that happens, there will be a ripple effect throughout the VC ecosystem.

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